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Opportunities In Options

In last month's newsletter, we commented on the increase in volatility in the financial markets to new three-year highs. We witnessed volatility doubling in the S&P 500 and increasing about 30% in bonds, and stated that: “This volatility will begin to subside and leave us with `normal' high volatility, which should present significant option selling opportunities.”

This is now what is occurring, and we have recommended neutral positions in the S&P (option volatility for the out of the money December puts is 40-50%!) and bonds to take advantage of these opportunities. As I also stated at that time, an additional benefit to the option seller is that we normally have a gradual lessening of option volatility during the December holiday period, that will further quicken premium decay of the options that are sold.

So you had a difficult trading day, week or month. Do you look at the next opportunity that comes by and say to yourself, “I was wrong on the markets (or my trading plan didn't work, etc), so I better not trade, because it will just happen again”; or do you disregard what happened before and just “jump in” saying: “That loss was an unusual situation. This time will be different.”

Actually, both approaches are wrong! Analyze and learn from your past losses; then act swiftly and optimistically on the next opportunity! Bob McGovern (Commodity Futures Spreads), a seasoned trader, discusses how he attacks the markets every day with an optimistic outlook, learning from hard times; but not allowing difficult trading periods to cloud his outlook for the future: “Sometimes the images of our old (negative) experiences appear and say, `Well just look at yesterday, it wasn't so good,' or `Look at last year, it was a bummer!' But, opportunity constantly knocks at every man's door. Every day is a fresh beginning. Every day we expect new things to happen, better things.”

I appreciate these words, because this is exactly the way I look at every trading day. The slate is clean; keep a sharp eye out for new opportunities. The winners in trading learn from past experiences, but don't dwell on them or get discouraged.–“If we can conceive the image of success, with feeling and conviction, we will find it in our experience!”

Fundamental Balances Likely To Keep Bonds

In Wide Trading Range; We Recommend

“Wide” Neutral Positions In March

After consolidating in early November, bonds rallied to new contract highs as escalating concerns over the Asian monetary crisis drove money to the safety of U.S. bonds now face some resistance from fears that Japanese institutions will have to sell some of their U.S. Treasury securities in order to raise capital to take care of serious problems at home. The failure of Yamaichi Securities (one of the “big four” of Japanese brokerages) has sparked concerns that more financial institutions will follow.

On the positive side, the financials are likely to find continued buying interest from investors concerned about the future prospects for equities, as the global economic contractions and deflationary potential spurs the flight of capital from equities into Treasuries. “...bonds have a solid near-term future. Whether the bonds see flight to quality buying or value buying (due to a lack of alternative yields) hardly matters as the U.S. is widely thought to be in control of its markets!” (CRB Futures Market Service)

The consensus outlook for anticipated Fed policy at the December 16th meeting remains evenly balanced between no change and a possible quarter-point hike, as measured by the trading in the January Fed funds contract. Although volatility has retreated slightly from the recent peaks, bonds are still recommended for selling premium, as implied volatility is still above 9%.

In the March bonds, we recommend the “wide” neutral option position of selling the 126 call and 112 put for about $600. The margin is about $700, on option expiration in 12 weeks and the daily effect of time decay is $10.22. We recommend no more than one position per $5000 excess account equity. Computer analysis shows an 85% probability that the market will be in the profit range at option expiration.

Adjustments are recommended at 122 or 116; if the market closes beyond those levels, basis March, we recommend rolling the short option on that side out 2 full points, and selling additional premium on the other side 2 points closer to the market.

Take Advantage Of High Option Volatility

With Credit Spreads And Neutral Positions

After the strong decline in late October, we expected the likelihood for a “retest” of the market lows. In mid-November, the S&P moved back down to retest important levels near 900, at the same time that the big secondary indexes (NASDAQ, NDX 100, and Russell 2000) all retested their closing lows from October 27th. While this has served to alleviate more of the excesses, the market has yet to achieve levels of sustained selling and broad pessimism that characterized the last two important bottoms. The November-January time period is seasonally bullish, but “bigger picture” problems mostly dampens the effect.

We recommend taking advantage of high option volatility in the out-of-the-money puts and calls with the neutral option position of selling the 1020 call and 800 put for a credit of about 400 points ($1000). Margin is about $6,000, and we recommend no more than one position per $15,000 in excess account equity. Time decay is $99.27 per day. Computer analysis shows an 88% probability that the market will be in the profit range at option expiration. We recommend the following trading plan for risk control: On the call side, if the market trades above 985, sell another put, and if the market trades above 995, roll up the 1020 calls. On the put side, if the market trades below 945, sell an additional call, and below 930, close the trade.

Diversify Among Commodities That Could Benefit

From This Major Weather Event

The El Nino trading package is our buy-and-hold position in a “basket” of commodities that can be severely effected by this major weather event. The projections for the intensity of this year's El Nino have varied as it has developed, but it clearly has the potential to rival or exceed the intensity of the 1982-1983 episode, the strongest of the century. “The 1997 episode is still only 6 months in the making...Given the early intensity of the 1997 pattern, one can conclude that there is at least a good chance that late 1997 and early 1998 could end up being one of the more `abnormal' weather years of this century...In '82/'83, overall losses to world economy resulting from climate changes amounted to $8 billion.” (CRB Futures Market Service.) Considering the tight global supply/demand fundamentals already, this weather pattern could add fuel to the fire if major rallies unfold. These markets have all been at much higher prices in the past, and a strong rally could be accompanied by an explosion in implied option volatility, which would greatly benefit these out- of-the-money calls. Since we are just entering the time period when the real effects of this phenomenon are starting to emerge, now is the time to establish small positions in a number of markets, any one of which could become a “home run.” The recommended trading positions grid shows our suggestions for this strategy.

Pulls Back To 50% Retracement Of November's Rally

During the first 3 weeks in November, action in silver was very bullish, moving up steadily since the late October lows, to the resistance near 540.

Reports of very tight stocks at the COMEX brought on speculations about a potential “squeeze,” with the deliverable supply of stocks (at 12-year lows). Also beyond this short-term potential, supply/demand fundamentals are bullish long term. Industrial demand is strong in the U.S. and Japan, and India has been “buying the dips.” Technically, the weekly charts have put in a higher low and high, which indicates the potential for a move up to resistance areas near 580-600. A long-term downtrend line has been broken, and previous resistance should now provide support. A 50% pullback of the current rally would take the market back to about 515-510 SIH, and we recommend using weakness to establish new trades.

On pullbacks, we recommend the bull call spread in July silver of buying the 550 call, and selling the 625 call at a cost of about 16 cents ($800). These options have 28 weeks until expiration. As a stop-out point, we recommend risking half the premium, or a close below 475 March, which is below the July- October bullish trendline. We also recommend using rallies to `roll up' the long calls to take some profits.

Big Volatility Disparity Between

March And July Presents

Great Opportunity For Calendar Spread

Orange juice started November with a strong rally, moving up to new 3-month highs, with speculative activity driving option volatility to 3-year highs. This rally provided a good opportunity to take profits on bullish trades we recommended near the 20-year lows. However, the fundamentals in this market, along with commercial activity, argue that significant gains from here will be difficult until significant changes are perceived to be developing. The current crop is record large, with the El Nino weather pattern actually being beneficial for the Florida crop, as this warming trend reduces freeze threats.

Due to the extreme volatility disparity between March and July options, we have an opportunity to establish a calendar position. We have potential to own a July option at a significant discount, which will still have about 4 months of life left until expiration. Up until now, the price movements in these contracts has been equal, so even a continuing rally would be likely to benefit the trade. Finally, the futures are trading at abnormal disparity, with March at a high premium to July. Most of the big rallies in juice have historically started in the January- March time frame, and given the current fundamentals we would expect this year to come later than sooner, which would give us a great opportunity to benefit from the July call after the March has expired on February 20th.

In orange juice, we recommend the calendar spread of buying the July 100 call, and selling the March 100 call for a cost of about 250 points ($375). The March options expire in about 12 weeks. For risk control, we recommend evaluating the trade if March juice reaches the 100 price. Option analysis shows that this should actually favor the trade, unless it occurs almost immediately, and the volatility disparity becomes even larger between the two months. With the implied volatility of the March 100 call at about 66%, and the July at about 40%, the March is about 65% higher, a significant disparity.

December 1997Opportunities In Options

Financial Plaza

300 Esplanada Drive, Ste. 200, Oxnard, California

Options Opportunities In Options

Spread Trading
Consensus National Futures and Financial On Line Index

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